What type of accounting books do I need? This is not only one of the very first questions asked by a new business owner. It’s something that comes up again and again as a business grows and evolves. Every business is doing some kind of accounting. But there’s a lot of confusion out there about the “Big Accounting Question”. And in reality, it’s not just Cash versus Accrual accounting. A lot of companies do something in between.
Cash Accounting Method
Let’s start with the most straightforward type: Cash accounting. (We’ll capitalize “Cash” and “Accrual” when we’re referring to the accounting methods). Cash accounting has the simple framework of being completely tied to cash entering or leaving your bank account.
Cash is great for many small businesses and, despite what is commonly suggested, many medium and large businesses. It is both simple to set up and simple to maintain. A list of bank transactions is easy to keep track of and categorize.
Cash accounting has two fantastic benefits
- It contains for most people everything that is required to create an IRS tax return (see the exceptions below);
- It can double for most businesses as a very accurate report to help manage your business.
Cash basis should be the default decision because there is no better cost/benefit way to tackle your accounting. That said, this may not be an option for you if you meet any of the criteria below. Additionally, there may be reasons to move incrementally to something more like accrual. For most companies, they settle on what we at Suitless like to call “Modified Accrual Accounting”. We’ll visit this in the following blog post on “Accrual versus Modified Accrual”.
Cash accounting might not be an option for you.
You are probably required to keep Accrual books, kept to IRS Accrual standards, if you report over $25 million in annual sales or hold significant inventory as part of a retail or business.
Keep in mind that Accrual books kept for the IRS are not the same things as GAAP-compliant books. The latter are Accrual but have many different rules than what the US Government outlines in IRS Publication 538.
Another important caveat: if you do business with the US Government, you might have to keep DCAA-compliant accounting books for the purposes of either an audit or to bill them variably per the terms of your contracts. DCAA-compliant books are their own animal and beyond the scope of this post.
Accrual Accounting Method
So what is Accrual accounting? Rather than match each individual accounting system transaction to a cash transaction, the Accrual concept is to match them to the time period in which the associated activity took place. The time period we commonly see is monthly, although it can sometimes simply be annual.
Here’s what Accrual accounting looks like in practice
- Salary costs should be expensed when the employee worked, not when they were paid;
- If you prepay for a year’s worth of web hosting, you should expense it as it’s used, e.g. monthly;
- If you bill a client for a day of work you fully performed, it’s revenue in the month you did the work, not the month you were paid.
Accrual also carries with it a second major rule, which is to “match” revenue and associated expenses to the same period. Let’s do a single example to demonstrate this one. If a catering company works an event, they should book the revenue in the month the event takes place, even if they collect payment at a later date (for example, under net 60 terms). Additionally, all the costs of putting on the event (food, labor, travel, etc.) should be expensed in that same month. That’s even if the food was purchased in a prior month, or the employees were not paid until the following month.
Further Accrual considerations
Moving from Cash accounting to “true” Accrual accounting represents a significant jump in the time and investment required to keep your books. There are two other major issues with Accrual that need to be considered:
- You cannot simply declare yourself Accrual without specifying under what set of rules you operate. It’s like asking someone to referee a game of football. You would have to make it known if you were following NCAA rules, or those set by the NFL, or something else entirely, like those used in Canada. To get back to accounting, you will usually follow IRS rules or those regulated in the U.S. as Generally Accepted Accounting Principles (GAAP).
- True Accrual accounting is often difficult and sometimes impossible to use as a business owner to run your business. The amount of “accruals” (revenues and expenses booked that are not associated with cash) can cloud the picture for someone trying to manage day-to-day operations. Things like complex deferred rent schedules, stock-based compensation expenses, and even revenue recognition for complex contracts can sometimes fully muddy the reporting. What most commonly happens at Accrual companies is that the accounting group must keep a “shadow” set of books. These exist so that business owners and managers can actually interpret business performance, i.e. managerial accounting. This is just another additional cost to expect if you want or need to move to a “true” Accrual method.
Do you need true GAAP-certified books?
If you’re reading this, almost certainly not. Only publicly traded businesses and those regulated by the SEC must keep Accrual books. Also those in the process of getting ready for an IPO. Its primary function is allowing investors to compare companies to each other, knowing the reports are following the same set of standards.
There are times when a non-publicly traded company voluntarily opts for Accrual GAAP-compliance. The most common example is a venture-backed startup that is growing rapidly, with hundreds of millions of dollars in investment. The board of directors tells them to do so for assurance purposes, so that the company can be independently audited. When doing this, don’t take lightly the significant cost both in terms of in-house accounting as well as auditor and consulting fees that will be associated with the project.
So to summarize: “true” Accrual accounting requires a qualifier, is very expensive and complex, and can actually create useless managerial reporting. It’s sometimes required. But there’s nothing inherently superior about the method compared to Cash accounting. In our opinion, avoid it unless there’s a compelling regulatory or business case for using it. That’s why we suggest a popular alternative.
Modified Accrual Accounting
Modified Accrual Accounting can have a couple of different names but we like this one. The general gist is this: you start with a base of following Cash basis methods, but you record a couple of types of transactions on an Accrual basis. Unlike “true” Accrual, you set your own rules here.
For most types of small to medium-sized growing businesses, this is by far the best way to go. It combines several advantages:
- Still largely cost effective;
- Easy to understand the reports without having to factor in complex non-cash accounting transactions;
- Very straightforward for your tax accountant to adjust for your tax returns
- Ease in sharing results reports with outside groups like banks and investors.
- Does not prevent you from taking the good data created with this accounting method and restating your books as GAAP compliant (a project, of course, that will require time and money).
When to switch from Cash to Modified Accrual Accounting
We see companies that are beginning to grow rapidly often find Modified Accrual aAccounting a good alternative. It is useful to managers, board and investors alike. And it can be a smoother transition if there is a long-term exit/IPO plan and one needs to prepare 2-3 years of “true” accrual accounting down the road.
Here are some examples of businesses that might want to move from Cash books to Modified Accrual books:
- A company with very large annual or multi-year deals and lump sum payments. Allocating large contracts as monthly revenue can help a business owner better understand what their monthly operating budget should be and gives a more regular-looking view to those outside the company.
- A company that bills separately each month without recurring revenue. It recognizes the revenue when it is earned. This can help a business owner better understand the health of the sales efforts each month, rather than something clouded by a couple of clients that pay irregularly. (That type of revenue recognition needs to be paired with a frequent review of the state of unpaid invoices, or Accounts Receivable).
Modified Accrual accounting books can make your reporting a little more reflective of what’s happening day-to-day. Things like labor, large prepaid supplies, or rent payments that aren’t paid monthly can be included in the Modified Accrual accounting books.
“True” Accrual incurs a lot more resource allocation than Cash and Modified Accrual accounting. You typically need a staff accountant and some dedicated professionals to sift through your books each month and match expenses with contracts and time periods. It can cause a lot more journal entries if you’re trying to transition from Cash to Accrual accounting. Modified is the way to go.
We’re fans of Modified Accrual Accounting, if you can’t tell. Unsure about where you stand? Need help looking at your real situation? Book a 15-minute call with us to look at your business’s situation. We’re here to help: email@example.com.